The Fed Model: The Bad, the Worse, and the Ugly
IESE Business School
The negative relationship between stock market P/E ratios and government bond yields seems to have become conventional wisdom among practitioners. Both limited empirical evidence and a misleading suggestion that the model originated in the Fed are used to support the model's plausibility. This article argues that the Fed model is flawed from a theoretical standpoint and reports evidence from 20 countries that seriously questions its empirical merits. Despite its widespread use and acceptance, the Fed model is found to be a failure both as a normative and as a positive model of equity pricing.
Number of Pages in PDF File: 29
Keywords: Fed model, P/E ratios, cointegration, earnings yields
JEL Classification: G11, G12
Date posted: January 21, 2006